Many banking crises of the past have followed a similar pattern: Starting within a positive macroeconomic environment followed by a successive boom including a massive expansion in financial assets, a sudden shock causes a downturn. Major emerging economies have experienced solid growth as well as a substantial rise in commercial bank lending over the past years. The share of bank loans as a percentage of GDP in these markets has increased, from about 77% of GDP in 2007 to 128% in 2015. Commercial loans have even been growing faster than the economy as a whole according to the new study “Better safe than sorry – Mastering hidden risk in the loan portfolio” conducted by Roland Berger. “These are signals that more volatile times for banks might be just around the corner,” explained Adrian Weber, Partner at Roland Berger. Further, the uncertainty spawned by the UK’s decision to leave the EU might also have an impact on loan performance and NPL growth.
According to the report, in India the total volume of commercial bank loans has increased from USD 140 billion in 2009 to USD 820 billion at a compound annual growth (CAGR) rate of 43%, while GDP has only grown at a rate of 8% per annum. In other major emerging economies such as Brazil, Turkey or Nigeria the picture looks similar within this period.
“Several emerging markets are either already experiencing economic slowdown or expect worsening economic outlooks. Sooner or later, these developments will hit banks, testing the quality of their loan books. As risks may reach across borders, it is time for banks, particularly in emerging markets, to prepare themselves,” said Knut Storholm, Partner at Roland Berger.
Taking preventive measures by assessing the loan book
Banks facing an economic recession or decline are usually hit twofold: shrinkage of the loan book constricts gross interest income, and the legacy of a previously ballooned loan book – entailing low-quality clients – drives up provisions on non-performing loans. In order to steel themselves against more volatile business environments the Roland Berger experts advise banks to conduct a loan book review in order to obtain a solid understanding and closely monitor the development of their exposure. “A thorough understanding of the loan book serves a wide variety of purposes. These are not limited to simply getting a better grasp of the existing risk exposure, but this understanding also serves as the basis for deriving improvement potential for processes, standards and guidelines, as well as for developing an early warning system,” explained Weber. Among the benefits outlined are short-term improvements such as increased transparency, the early identification of risky clients and the avoidance of sudden provisions and losses as well as mid-term advantages, namely the strengthening of credit underwriting, the improvement of operational processes and the alignment of strategy with bottom-up findings.
Looking beyond traditional financial indicators
Financial institutions already generate a substantial amount of data when interacting with clients and assessing their risk. However, credit risk is frequently only assessed via rudimentary analytics and limited to a few traditional financial indicators. These indicators do not encapsulate the full picture of credit risk and are typically backward-looking. “As a result, traditional credit reports and risk scores do not provide a reliable and transparent view of the underlying risks. There is significant and untapped potential to enhance risk assessment capabilities and to implement a truly foresighted protective approach,” said Weber. Combining financial and non-financial indicators for detecting patterns has proven to be the most fruitful approach. Though non-financial and behavioral indicators may be more difficult to include, this should not stop them from becoming a part of the loan book review and early warning system.
Going for a customized approach
Even though a loan book review follows certain steps, there is no one-size-fits-all approach. According to the Roland Berger experts it must be adjusted to both external and internal factors as well as to the particular needs of the bank. Country-specific aspects, such as bankruptcy law, are crucial elements that must be taken into consideration. Macroeconomic factors have diverging impact on industries and therefore need to be evaluated in line with industry specific developments. On top of this, the bank’s general positioning in the market largely defines its exposure and risk profile, and must be reflected in the conclusions derived from an assessment. “If a loan book review takes all these variables into consideration, it will help uncover predictive indicators thanks to its deep insights into the way clients’ behaviors may be changing. As such it builds the solid foundation necessary to take suitable preventive measures, build an early warning system and become aware of – and ready for – the looming risks ahead,” said Storholm in summary.
